Once again, surveys show that trust is declining. The latest AP-GFK poll reveals that only one third of Americans feel that most people can be trusted, down from half who felt that way 30 years ago. The report summarized why this matters by giving examples of the pressures that result.
“Social trust results in a society where it’s easier to compromise or make a deal. Where people are willing to work with those who are different from them for the common good. Where trust appears to promote economic growth.
Distrust, on the other hand, seems to encourage corruption. At the least, it diverts energy to counting change, drawing up 100-page legal contracts and building gated communities.”
So if contracts are one consequence of low levels of trust, might we force new and more trusting approaches by scrapping them?
Certainly adversarial contracting built on classical legal theories of risk allocation reinforces the absence of trust. It assumes there is a probability of poor or dishonest performance which may lead to a need for retribution or recompense. This approach is also endemic to the United States and has been transported to many other parts of the world by global corporations. It is sustained by a growing number of lawyers because it is what they are taught to do in law school.
We know from annual IACCM surveys that it is these risk-related terms that dominate much negotiation (indemnities, liabilities, liquidated damages, IP rights etc.). Therefore I would contend that contract and negotiation practices as pursued by many companies and law firms are indeed contributing to the erosion of trust and we might well be better off if they were banned.
But what would we lose if we had no contracts? Let’s say for a moment that we restricted the use of contracts to those who had at some point been shown untrustworthy. This would have the benefit of punishing dishonest or manipulative behavior, marking out such companies and increasing their cost of doing business. But would everything then work out well?
Our research suggests that it is not contracts that are the problem; it is traditional, legally-dominated contracts. In today’s more complex, outcome-based world, organizations need a disciplined way to ensure mutual understanding. Whether they trust or not, they are often dealing with complicated issues with many possible interpretations. They are also often dealing across cultures and languages. Opportunities for honest misunderstandings abound.
And that is why IACCM promotes a new perspective on contracting – as a mechanism to build confidence and trust, rather than to undermine it. Such an approach drives very different conversations and also very different contract design. Contracts become management tools, providing a clear baseline, being used for communication throughout the organization. They are most likely electronic and may never be printed. They are regularly referenced to establish how conditions or needs have altered and how the baseline needs to be adjusted.
A few weeks ago, I wrote about the use of virtual reality in building design – a highly disciplined approach that forces the parties to be precise about their goals and needs. This is not driven by a lack of trust, but rather to establish mutual agreement and confidence, resulting in lower costs, more timely delivery and higher quality. I suggested then that we need to think similarly about creating ‘virtual reality contracts’, where the parties convert their discussions into the opportunity for a ‘walk-through’ of the contract, such that it builds accord and true cooperation.
I am sure that Starbucks did not expect to face a $2.8bn settlement when they decided to terminate their distribution agreement with Kraft. In their minds, there had been ‘material breach’ – and indeed, based on subsequent performance, it does appear that Kraft was not doing a great job.
But this case study shows the importance of being clear about business objectives and, in any long-term agreement, the need to periodically review and update them. It also illustrates a need for effective governance and performance management principles and clarity over their enforcement, as well as the extent to which they contribute to ‘materialism’.
There is an excellent summary of this recent dispute in a recent edition of Inside Counsel and it can be accessed here. Of course, it is easy to point to issues with contract drafting, or perhaps the judgment that led to unilateral termination (always a risky decision). But in the end, was it really legal issues at fault, or the absence of adequate contract and relationship management? Why did issues either build up or fester in such a way that the communications between the respective CEOs became so hostile? was there a robust contract and performance management regime and if so, was it followed?
The legal issues around material breach and rights to terminate are critically important, but it is the operational aspects of the relationship that will determine whether issues are resolved amicably. Contracts provide the framework and good contract management ensures that framework is followed, and also that it is updated and maintained. it also ensures that problems are identified early, addressed collaboratively and, when necessary, escalated to relevant executives in a timely manner.
i have no idea how much this was happening at Starbucks or Kraft. But at least for Starbucks, it has been an expensive lesson.
At this week’s IACCM workshop in Sydney, Morag Lokan (Assistant Commissioner at the Australian Taxation Office) presented her thoughts on the role of relationships in contract management.
Among her charts, she set out a list of factors to be considered when evaluating the potential nature and depth of the relationship. I have expanded these slightly, to produce a set of ten.
- What is the likely duration of the contract?
- How many organizations and stakeholders are involved?
- Does your organizations speak with one voice?
- Have the suppliers worked together before (and with what result)?
- Have the suppliers worked with your organization before?
- Are they competitors?
- How important is the contract to your organization?
- How committed is your organization to making this work?
- How committed are the suppliers to making this work?
- Is there evidence of relational capability?
Last week I wrote about the growing debate over supplier integrity versus buyer competence – and the suggestion that if a buyer lacks contract management skills, they should not engage in complex contracting. (See original post here).
The issue has hit the headlines because of accusations of supplier fraud – deliberate overcharging of customers. This appears to have become more endemic as the world moves to outcome and output based contracts, with more complex charging formulas than a straightforward purchase agreement.
Anyone who has read this blog over the last 5 years will not be surprised that the absence of investment in contract and commercial skills has resulted in major problems. Trading conditions have become more complex; many organizations have adopted new acquisition or delivery models; markets have become more volatile. Yet while IACCM research has revealed that executives recognize the need for enhanced commercial capability, this has rarely translated to major improvement or change.
So what should be done? Two immediate ideas for improvement are:
- Capability maturity assessments. Already, many buyers require that their suppliers are audited for regulatory compliance (environment, bribery and corruption, labor practices etc). Often these are conducted by third parties. Assessments of commercial and contract capability could be the basis for supplier selection – or indeed of selection of customers by suppliers, since integrity in this field goes in both directions.
- Relational contracts. The principles underlying ‘relational contracting’ are focused on improved partner selection (pre-award) and governance and performance management (post-award). By clearly defining the mechanisms through which these occur, relational principles not only ensure insight to capabilities, but also create a framework for shared operational management.
Many organizations have been slow to grasp the fundamental impacts of a switch from traditional input-based buying to the more complex environment of procuring outputs and outcomes. The reaction of many has been to boost procurement practices that focus on lowest price rather than highest value and are accompanied by aggressive risk-transfer, together with reduced loyalty to long-term suppliers. These practices have the effect of limiting competition and undermining supplier commitment to performance. It could be argued that they encourage unscrupulous behavior – though there are those who would question whether any supplier is scrupulous if they think they can get away with it.
Remember “The World Is Flat”, the best-seller by Tom Friedman that hailed a future of open competition and innovation driven by a global networked economy?
Just how true have those forecasts proved to be? For a brief period, we certainly saw aggressive action on input prices as low cost economies provided multiple opportunities to outsource or offshore both manufacturing and a wide array of services. Procurement practices evolved around the theory of endless competition, placing most suppliers in a defensive position as they fought to maintain margins and market share.
Yet ironically, while global markets have clearly produced some new suppliers, in many industries the level of competition seems to have dropped. Innovation, consolidation, altered levels of dependency, increased teaming – these are among the factors that have led to shifts in buyer / supplier power in industries such as oil and gas, automotive and pharmaceuticals.
But what about the IT industry?
The UK’s National Audit Office has issued a damning report on the state of contract management in the outsourcing industry, questioning the integrity of suppliers and suggesting a lack of competence in Government departments to manage such relationships.
Given the findings and observations of the NAO and recent investigations by the UK Public Accounts committee, what steps should suppliers and customers be taking to raise the quality and integrity of contract performance? It is clear that obligations and commitments need more rigorous analysis, both in terms of capability to deliver and in actual delivery. But is this a shared responsibility, or does the burden fall disproportionately on one party? And within this, where does organizational and operational responsibility for ‘due diligence’ lie; for example, should highly trained contract managers be more directly responsible for signing off against commitments and the oversight of internal integrity? Given their operational role, might this be more effective than oversight by risk or audit functions, which tend to report after the fact?
It would be a mistake to see this as a problem that is peculiar to the UK. Repeated issues in the US (where there is supposed contract management rigor) suggest similar challenges. And the experience of many private sector firms has in truth not been much different.
Until these issues are resolved, publications such as the Financial Times suggest that organizations should not enter into complex contracts where they do not have the capabilities for their management. But is it management that is the problem, or is it the selection criteria? In other words, an organization that lacks contract management competence probably does not understand its value and therefore does not look for this quality in its suppliers. Indeed, suppliers with strong contract management discipline are quite likely to lose a competitive tender because a) they will be more conservative in the commitments they make and b) they are likely to bid a higher price. The reasons for this are that a strong contracts or commercial function acts as a constraint on the natural over-optimism of Sales and senior management; and such organizations generally do not follow a model of ‘bid low and make up margin later’. This latter attitude, induced by price-based supplier selection, leads to low levels of supplier integrity, which include aggressive pursuit of claims and a readiness to deliberately over-charge.
But does this mean that for complex relationships to work, both parties must have equal competence in contract management? I think the answer is no; but the weaker party must certainly appreciate their potential exposure and select and manage their trading partners accordingly. Processes that are driven by a conjunction of price-based procurement and risk-allocating contracts is clearly not adequate – and may even drive the opportunistic behavior that is evident in some suppliers.
Tomorrow, I will suggest some mechanisms that might address these problems.